What the HUI?!?

After weathering a consolidation running for 16 months now, the remaining
precious-metals-stock investors and speculators are a pretty hardened lot.
Used to being the ridiculed black-sheep contrarians, it takes quite a bit to
faze us. Yet the brutal downside action in the HUI last week certainly fit
the bill.

Between Monday the 13th and Thursday the 16th, the HUI unhedged gold-stock
index shed 18% of its value on an intraday basis. Wednesday and Thursday were
the particularly nasty days, with 3/4ths of these losses occurring between
the open Wednesday and the first couple hours of trading on Thursday morning.

While this sounds bad enough at the index level, the 14% HUI loss over about
8 trading hours really belies the real carnage underneath the surface. Excellent
gold and silver juniors with outstanding fundamentals were trapped in a sickening
freefall. Some plummeted on the order of 20% per day at worst during
the HUI mini-panic of mid-August 2007. It was truly an extraordinary event.

Although this sector has started to recover since last week, the psychological
aftermath of this event will continue to wreak havoc on PM-stock sentiment
for some time to come. The fact that the HUI can plunge so fast with no warning,
off a technical low no less, has really damaged confidence in the struggling
precious-metals-stock sector.

Relatively conservative speculators who own their stocks outright and prudently
run trailing stops saw almost all of their speculative positions get stopped
out last week. While their capital was recovered with just modest losses thanks
to their stops, they now find themselves with a blank PM-stock slate and trying
to decide whether or not, and when, to redeploy this capital in PM stocks.

And aggressive speculators who borrow money to buy stocks were eviscerated
in the carnage. Margin is great when stocks are rising and gains are multiplied,
but when stocks fall fast this same leverage leads to spiraling uncontainable
losses. I have no doubt that some heavily-margined PM-stock traders lost nearly
everything last week and are now out of the game for good. They'll never buy
another PM stock again.

In light of this, the most common question I hear as traders try to digest
last week is "what the heck is going on here?" In addition to trying to understand
just what happened last week, PM-stock traders are very concerned about the
health of the PM-stock bull today. I don't blame them. Last week was a real
wake-up call on the ever-present risks and dangers always inherent to, but
usually ignored in, speculation.

As always, my detailed tactical analysis of the HUI mini-panic events as well
as specific trading strategies and stock recommendations going forward are
being discussed in depth in our subscription newsletters. Our subscribers
fund Zeal and make all of our research possible, so they naturally get the
best actionable information. But zooming way out, important strategic questions
have also arisen about the integrity of this HUI bull that are very appropriate
for an essay.

With support so decisively broken, is this HUI bull over? Was the record PM-stock
trading volume witnessed last week a bullish or bearish omen? Does the HUI's
relentless underperformance of gold lately suggest gold is no longer the primary
HUI driver? Is the once-alternative PM-stock sector doomed to trade in lockstep
with the general stock markets? Such questions are really vexing PM-stock traders
today.

As always, the history of this bull offers insights that help frame the present
in proper context. Although Thursday the 16th, a two-hour mini-panic off of
technical lows, was largely unprecedented in this bull, there are certainly
broader parallels between last week and past HUI behavior. The selling last
week may have been unusually temporally condensed, but it certainly wasn't
the first setback in this seven-year-old bull market.

To address these concerns, this first chart combines HUI technicals with its
trading volume. The latter is daily composite HUI volume, or the individual
trading volumes of all of the HUI's component companies added together. If
you look at a HUI chart of just the past month, it looks pretty darned ugly.
But pulling back to see the mini-panic in broader context really helps put
it in perspective and calm seething fears.

Let's start with the technicals. Since last week's sharp selloff broke the
HUI's latest support line decisively as well as drove the index well below
its crucial 200-day moving average, a growing number of technically-oriented
traders are fearing this bull market is over. Support failures are indeed events
worthy of paying attention to. But last week's failure was not only not particularly
major, it wasn't the HUI's first by a long shot.

If you look closely at the upper-right corner of this chart, the support line
that was just broken and is causing all the commotion is labeled with the blue
4. While there is no doubt it failed spectacularly, it wasn't a very old support
line. In fact, it just started trending higher at the January 2007 lows. So
the particular support line that failed last week wasn't even secular in nature,
but a short-term one less than 8 months old!

Interestingly the current secular, or long-term, support line remained intact
despite last week's mini-panic. It is the only one labeled as Support above.
It was born off the June 2006 HUI lows following the index's all-time high.
Later it was cemented in place by the October 2006 lows. They ran near 274
and 283 respectively. On the Thursday of the mini-panic, the HUI closed right
at 300 which keeps this quasi-secular line intact.

Now not all technicians agree with me, but for long-term technical
analysis I am convinced only closing prices are relevant. While all kinds of
sentimental distractions can drive wild intraday trading from time to time,
it is the closing price that truly distills what the markets thought stocks
were worth on any particular day. Big intraday swings just don't mean all that
much in the grand scheme of things.

And on a closing basis, this latest HUI support line that was not broken last
week is about 14 months old. It isn't exactly secular in duration yet as that
term usually applies to multi-year spans of time, but it isn't tactical either
since it has persisted for over a year. And this older, and hence more important,
line held strong while short-term support failed.

But even if this quasi-secular support line had failed, or it does fail in
the coming weeks, it is hardly evidence that this PM-stock bull is ending.
Prior to this, there have been at least three major support breakdowns in the
HUI that are labeled above with the blue numbers. In each case the HUI fell
decisively under its most important long-term support line, panicking pure
technicians, but its bull soon recovered and continued higher to establish
new support lines. Support always evolves throughout a bull.

The most relevant of these major support breakdowns to today was the second,
starting in early 2005. The HUI had been powering higher along secular support
established way back in late 2002. During its 2.5 years of existence, this
crucial support line had even held through the sharp correction following a
massive upleg in mid-2004. So when it suddenly failed in early 2005, technicians
started freaking out.

Naturally when this earlier breakdown happened, sentiment was horrible just
like today. Investors and speculators alike were giving up on PM stocks and
throwing in the towel. Ever the contrarian, I was trying to fight the irrationally
pessimistic HUI sentiment back then just as now. In February 2005, I was writing
about the bullish
gold fundamentals and about how the gold-stock
bull was healthy despite popular perceptions. By April, as the HUI started
to bottom, I wrote about the very
bullish opportunities in unloved gold stocks.

Most tellingly though, also in April 2005 near the major HUI lows I felt the
need to write about the
HUI's correlation with the general stock markets. Back then, just like today,
traders feared that the HUI was joined at the hip to the SPX so any stock-market
selloff would crush PM stocks too. Despite it being irrational in light of
history, folks were using a perceived HUI/SPX correlation as an excuse to avoid
being contrarians and buying near oversold lows. There is really nothing new
under the sun in the markets!

In many ways, the early summer of 2005 is very analogous to today. As you
can see in this chart, the HUI seemed to be growing weaker as its long consolidation
kept grinding forward. And the HUI was unable to revisit its pre-consolidation
highs again despite trying for over a year. And it continued to get weaker
as despair set in and traders gave up on PM stocks. Sounds just like today,
no?

Most everything witnessed today in 2007 also happened in 2005. The job of
a long consolidation is to spawn despair, shake weak hands out of a sector,
and build a base for the next fundamentally-driven upleg. Once despair is maximized
and no one is left in a sector but fearless true believers in the fundamentals,
then the sector can soar. Indeed the HUI's latest massive upleg was born out
of the naked despair of the mid-2005 technical and sentimental lows. The next
one is probably being born today.

So yes, even long-term support fails from time to time. Yes, traders succumb
to fear and despair during long consolidations when new highs aren't achieved
quickly enough to slake their greed. But ultimately all that matters is fundamentals.
If the HUI's fundamentals remain bullish, it will rise. Since the HUI's primary
driver is the price of gold, it is gold's
fundamentals that traders should consider today. If gold demand growth
is going to continue to exceed gold supply growth worldwide, then the HUI will continue
higher sooner or later.

With the HUI really doing nothing particularly appalling technically last
week other than its intraday Thursday panic selling, we can move on to volume.
Volume in gold stocks soared to record levels on Thursday the 16th as leveraged
speculators were skewered and forced to dump their PM stocks at any price.
This mini-panic only lasted for a couple of trading hours, which is why I call
it "mini", but composite HUI volume still rocketed up to a massive new all-time
record.

On that Thursday alone, 160m shares of HUI component companies changed hands.
Prior to this the record was 106m on February 27th of this year, the day the
US stock markets sold off sharply on the back of a wicked single-day 9% slide
in Shanghai. Prior to August 16th the average daily HUI volume in 2007 was
running around 62m shares. So to see 2.6x normal volume is pretty extraordinary.

Now in volume-based studies of the markets, high-volume selloffs are usually
much more relevant than low-volume ones. If a selloff happens on low volume,
it can just be attributed to lack of buyer interest in a thinly-traded market.
But if it happens on high volume, then technicians fear the mass exodus may
mark the beginning of a major trend change. So today traders are concerned
the stellar HUI volume during the mini-panic suggests that this HUI bull is
in jeopardy.

While the 16th was extraordinary, it was certainly not the first time in this
bull that a sharp selloff happened on very high volume. Three other high-volume
selloffs are labeled above with the red numbers. During each, the HUI volume
soared to levels that were very high or even records in the context of the
bull to date up to those points. Yet after each, the HUI recovered nicely and
continued higher on balance. Why? Volume doesn't drive secular bulls, fundamentals
do.

Although I agree that high-volume selloffs are more ominous than low-volume
ones, I disagree based on the HUI's bull-to-date precedent that last Thursday's
selloff volume alone is enough to build a bearish case upon. Traders get scared
from time to time, especially the leveraged ones. When some news spooks the
markets and the margined guys are forced to sell in a hurry, volume can spike
dramatically. Yet so far it hasn't heralded the end of the bull, just the end
of aggressive speculators who borrowed too much money. One of the most basic
lessons of market history is leverage tends to eventually bite those who use
it.

Just as with technicals, it is probably wiser to interpret volume within strategic
context rather than dwelling too narrowly on one particularly stunning episode.
Note the impressive uptrend in general HUI trading volume since the despairing
summer of 2005, which even persisted through our current consolidation. Higher
trading volume over long periods of time is a characteristic of bull markets,
not bear markets.

As more traders get interested in the PM-stock sector, more capital will chase
the PM stocks. Since all of the market capitalizations of all the PM stocks
combined remain incredibly small, like a quarter the size of a single big
oil company, it doesn't take much capital to drive prices higher. The rising
volume in the HUI shows rising interest in trading it despite the consolidation.
And the more traders and capital migrating into this small sector, the bigger
its fundamentally-driven uplegs will be.

With more capital paying attention as evidenced by volume growth, as soon
as the HUI starts following gold again big buying should flood in and drive
it higher. And of course rising prices in the financial markets create a virtuous
circle. The higher prices rise the more traders want to buy in to ride the
action. So they buy in and drive prices even higher, enticing in a whole new
round of traders, and so on. It is higher volume that starts this whole cycle,
so the growing volume in the PM stocks is encouraging.

The final two concerns I want to address today are like two sides of one coin.
Why is the HUI not following gold and why does it seem to be following the
general stock markets so darned well? Interestingly neither of these concerns
is anything new. Just like worrying about support failures, for the past seven
years of this HUI bull traders have been worried about the HUI's correlations
with gold and the SPX. Yet this PM-stock index has still powered nearly 1000%
higher over this period of time. Bulls climb a wall of worries.

We'll start with gold, and the easiest way to understand the HUI's interaction
with the metal that ultimately drives it is through the HUI/Gold Ratio. HGR
trends offer insights into whether the PM stocks are outperforming the
metal or vice versa. Interestingly this is very cyclical, with the metal doing
better for a considerable period of time and then the PM stocks finally catching
up and exceeding the metal. When the blue HGR line below rises, PM stocks are
outperforming. When it falls, gold is outperforming.

Overall in their respective bulls to date, the HUI has outperformed gold dramatically
by exceeding its gains by 5.5x to one. Yet this outperformance is not a constant
linear thing, it is achieved sporadically in big HUI surges. Today a lot of
traders are concerned because the HUI isn't responding to gold's impressive
strength. How can the HUI sell off so dramatically when gold remains so stable
at high levels?

As you can see in this chart, gold has been outperforming the HUI since just
before the May 2006 tops, or for this entire consolidation. On balance the
HGR has been declining. And this key ratio really fell during last week's mini-panic,
driving it to the lowest levels seen in a couple years. So is the HUI's poor
relative performance telegraphing that its bull market might be running out
of steam? I really doubt it.

Once again historical perspective is the key. Gold outperforms the HUI during every PM-stock
consolidation. Or more literally, the more volatile HUI falls farther during
its consolidations than gold falls during its own. The latest episode of the
HUI underperforming gold is the fourth we've seen so far in its bull. Yet just
as the first three episodes didn't mark the end of this bull, odds are this
fourth won't either.

The only times that the HUI strongly outperforms gold are during the HUI's
massive uplegs. While these PM-stock uplegs are driven by underlying uplegs
in gold, sooner or later greed grows too excessive in the HUI so it tops. Then
it starts consolidating sideways to bleed off greed and get the markets comfortable
with a new foundational base at higher HUI prices. Gold always exhibits relative
strength during these periods of time, retreating a lot less than its miners
do.

It is provocative that the weakest HGRs are seen late in consolidations. Like
today, PM-stock traders who refuse to study market history start to lose faith
when a new upleg tarries. The longer a consolidation lasts, the more traders
give up on the entire sector. Naturally the HUI gets weaker and weaker as this
despair grows, so the HGR tends to hit its lows for a consolidation near the
very end of the consolidation. PM-stock traders capitulate and leave despite
strong gold prices paving the way for the next upleg.

Looking at this chart, it is readily evident that last week's HUI mini-panic
drove the HGR to the lowest levels it has seen during this consolidation. The
HGR actually fell to its secular support line, which has held since early 2003.
It was from this very line that the previous two massive HUI uplegs launched.
Given today's levels of despair and disgust with the HUI, it wouldn't surprise
me at all if the HUI's next massive upleg is starting higher now. The HUI tends
to start outperforming again just when it looks the worst.

So based on the history of this bull, it is hard to make the case that something
is fundamentally wrong with the HUI's relationship with gold today. Sure the
HUI has been underperforming for this whole consolidation, but it did the same
thing in all its past consolidations too. Once again there is nothing new under
the sun. I think if traders understood this history, they wouldn't get so worked
up about the SPX.

Thanks to the HUI swooning with the general stock markets a few times this
year, the vast majority of the PM-stock-trading realm is now convinced that
the fortunes of the SPX are the primary driver of the HUI. So therefore if
the US stock markets continue lower, the HUI will have to sell off in sympathy.
This pervasive belief continues to boggle my mind as it defies the lessons
of market history.

Either precious-metals stocks are still classical alternative investments
or they are not. If they are, they tend to thrive the most when general stocks
are the weakest. The HUI actually did phenomenally well during the last wicked
general-stock bear between
2000 and 2002. But if PM stocks are now suddenly not an alternative investment,
then there is no reason whatsoever to own them. If we truly live in a world
where the SPX drives everything, then traders would be better off owning Wall-Street-darling
sectors.

The primary driver of the mini-panic last week, before the margined guys started
getting squeezed, was this overriding fear that the HUI is just another mainstream
stock sector correlated with the SPX. So as the stock markets sold off, HUI
traders who believe this thesis panicked. Just as in 2005, this is stratifying
the PM-stock market. Traders who fear the SPX are selling. But traders who
believe in history, that the price of gold drives gold stocks, are staying
deployed in the PM-stock sector despite all the fears today.

At this stage it really boils down to a faith issue, as it does late in all
consolidations when popular despair reigns. If you believe the price of gold
is heading higher for global supply-and-demand reasons, and therefore the profits
for mining this metal will rise, then there is no reason not to buy PM stocks.
If you don't believe this is the case, then there is no reason to buy PM stocks.
This consolidation will end when the latter group has largely sold out and
the former remains. Good riddance to these weak hands.

Of course at Zeal we remain very bullish on gold and commodities and the stocks
of the companies mining them. After countless thousands of hours of research,
writing, and trading since these bull markets launched, it is readily evident
that probabilities remain overwhelmingly on the bulls' side. So we continue
to ignore popular fears and buy elite PM stocks at technically-opportune times. Subscribe
today to our acclaimed monthly
newsletter and ride the next decade of this commodities bull higher with
us!

The bottom line is the mini-panic last week, while crazy tactically on the
16th, really wasn't all that exciting in strategic context. It wasn't the first
time the HUI has broken key support, nor the first time the HUI sold off on
high volume, nor the first time it underperformed gold. Such events are par
for the course deep in consolidations and are nothing to write home about.
Massive uplegs are born out of such fear and despair, as the best times to
buy are when the fewest traders want to.

While emotions can easily dominate short-term trading, over the long term
all that matters is fundamentals. For PM stocks, it is the prices of gold and
silver that ultimately matter. Higher metals prices mean higher profits, and
higher profits mean higher PM-stock prices.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for
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